The British Petroleum (NYSE:BP) oil spill is shaping up to be one of the largest environmental disasters in human history as millions of gallons of crude are spewed into the Gulf of Mexico, threatening to spread into the Atlantic and wash up on coastal areas that treasure their beaches. While this is an environmental tragedy to be sure, it is also beginning to take a very real economic toll on the fishing and tourism industries. As such, now is a good time to better understand economic externalities and how to prevent problems of this sort in the future.
What is an Economic Externality?
To answer this question, let's take a quick step back to understand the economy and how market participants interact. In the case of oil, we all need it for our vehicles - oil to lubricate the engine and gasoline to make it run. We purchase these products at service stations and pay a few dollars per gallon. The parties involved in this business include us (consumers) and all of the people, land, and equipment that produce the gasoline (factors of production). Anyone or anything not directly involved in the production or purchase are considered 'external' to the transaction.
The previous sentence is a layman's version of the definition, but to really answer the initial question, let's expand this into terms used by economists. From Baumol and Blinder's Economics Principles and Policy, 11th Edition:
"An activity is said to generate a beneficial or detrimental externality if that activity causes incidental benefits or damages to others not directly involved in the activity, and no corresponding compensation is provided to or paid by those who generate the externality."
This expands our previous definition by recognizing that no compensation is provided to or paid by the party that generates the externality. This is an important distinction, as external parties may either receive beneficial externalities (a neighbor improves her house, increasing property values for all in the neighborhood) or detrimental externalities (a neighbor abandons his house that is later vandalized, lowering neighboring property values).
Example: BP's Massive Gaffe in the Gulf
While smaller externalities exist and play out each and every day, the Gulf oil disaster is a very large scale look at the downside of externalities. Not only is BP losing money from the loss of oil, but the company will also be required to pay for much of the cleanup. However, it remains to be seen if BP will also be held responsible for losses in the fishing industry or the decline in summer tourism along the Gulf Coast. We suspect that over the next several months or even the next few years, the external costs of this gaffe will be uncovered and be the subject of many academic papers, news articles, and books.
As Congress and the Obama Administration continue to struggle with how to handle BP's abysmal efforts, they will no doubt have a long line of injured parties seeking damages from the company. Whether or not these parties receive any compensation will be a matter of law, but it is likely that no one will be made whole. The problem with externalities is they exist outside of the pricing of the markets. Until financial incentives and disincentives are put in place, we will continue to see problems like those in the Gulf occur time and again.